Pensions are Still Powerful
Tax Shelters

Enjoy Tax Relief on Pension Contributions

PENSIONS ARE still powerful tax shelters, despite the Government’s crazy clampdown on contributions made by high earners. Most people who earn less than £150,000 will still be able to carry on using the three big pension tax breaks.

• Tax relief on contributions. For every £80 you contribute the taxman will top up your pension plan with an extra £20, bringing the total to £100. If you are a higher-rate taxpayer (earning more than £43,875) you will also receive a £20 refund when you submit your tax return. Bottom line: For an outlay of just £60 you get £100 worth of pension investments.

• Tax-free investment growth. Your £100 will then grow tax free until you retire. For example, if you invest in a corporate bond fund paying 7% you could end up with almost £200 after 10 years. If you had invested the equivalent £60 outside a pension, you would pay tax on all the interest and end up with just £90 after 10 years. Bottom line: A pension saver can end up with over twice as much money as someone who invests without tax relief. 

• Tax-free lump sum. When you reach age 55 you can start tapping your pension savings and 25% can be taken as a tax-free lump sum.

Unfortunately ALL the remaining money you withdraw (both income and capital) is taxable but some will be covered by your personal allowance and most people end up paying just 20% tax on the rest.

In summary, if you earn more than £43,875 but less £150,000 you will probably still be able to save a lot of tax by contributing to a pension.

You should consider making contributions sooner rather than later because the Government has not promised to increase the £150,000 limit, which means you could hit it in a few years time. At that point contributing to a pension becomes a lot less attractive.

75% Tax Relief
Starting on 6th April 2010 you should definitely consider making pension contributions when your income rises above £100,000 in order to prevent your personal allowance from being taken away.

For example, let’s say Bill has taxable income of £110,000 in 2010/11 and makes a personal pension contribution of £80. He gets £40 back from the taxman as usual but the pension contribution also reduces his taxable income by £100, thus preserving an extra £50 of his personal allowance and saving him an extra £20 in income tax.

In summary, Bill contributes £80 and gets back £60 – a total of 75% tax relief!

Basic-Rate Taxpayers
What about basic-rate taxpayers earning less than £43,875 – should they contribute to a personal pension? Basic-rate taxpayers only enjoy tax relief at 20% instead of 40% on their pension contributions.

If you expect to be earning more and paying 40% tax next year or in a couple of years’ time, you may want to consider postponing your personal pension contributions until you are a higher-rate taxpayer. At that point you can make bigger catch-up contributions and enjoy the maximum 40% tax relief.

This is possibly the best strategy for business owners who see their incomes fluctuate up and down from year to year.

Postponing your pension contributions doesn’t mean you have to stop saving. You can still invest in ISAs.

Company Directors
Many company director/shareholders take a small salary and the rest as dividends. For example, for the current 2009/10 tax year many will be taking a salary of just £5,715 to avoid income tax and national insurance.

Dividends don’t count as earnings, so you will only get tax relief on a maximum gross pension contribution of just £5,715. Nevertheless, if your dividends are big enough to make you a higher-rate taxpayer, you will still enjoy the maximum tax relief on your contributions. In fact, because of the way dividends are taxed, total tax relief can be as much as 42.5%!

If you want to start upping your contributions before the £150,000 limit kicks in, one option would be to increase your salary so that you have more “earnings”. However, remember that any salary over £5,715 will start attracting national insurance – 11% paid by you and 12.8% paid by the company.

Although some of this will be tax deductible in the hands of the company, a lot of your pension tax relief could be eaten up by a higher national insurance bill.

A better bet may be to speak to a pensions adviser about getting your company to contribute directly into a pension scheme. The company will be able to claim corporation tax relief on the contributions and there will be no national insurance cost.

Property Investors
Like dividends, most rental income does not qualify as earnings, so full-time landlords cannot usually get tax relief on large pension contributions. However, they can still get relief on a gross contribution of up to £3,600 per year because that is the minimum for everybody. This equates to a cash contribution of £2,880.

Pension Drawbacks
Pensions are valuable tax shelters but they have two serious flaws. Firstly, because most of the money you take out will be fully taxed, you are a sitting duck when you retire. Our top income tax rate has just been increased from 40% to 50%. Who says it won’t be 60% or higher in a few years time? To hedge your bets you should also invest in ISAs – anything you take out will be 100% tax free.

The second serious flaw is you cannot get your hands on any of your money until you reach the minimum retirement age (55 from 2010 onwards). Bottom line: If you are worried about how your business will cope over the next 12 to 18 months, you should consider postponing personal pension contributions until conditions improve.

The £3 billion pension hit announced in the Budget will only affect those earning £150,000 or more and will only fully impact those earning at least £180,000.

From 6th April 2011, these individuals will have their tax relief reduced to 20%. The detailed rules have not been announced yet but Revenue & Customs has published some nasty penalties to stop high earners maxing out their pension contributions this year and next year.

These “anti-forestalling” provisions may apply if you have earned £150,000 or more in any tax year from 2007/8 onwards.

The good news is you can still enjoy higher-rate tax relief for the next two years even if your income is or was £150,000 or more, providing you continue as normal with your ‘existing regular’ pension contributions. For example, if you’ve been contributing £2,000 per month over the last couple of years, you can carry on doing so until April 2011 and enjoy the maximum tax relief.

By ‘regular’ HMRC means monthly or quarterly contributions – anything less frequent, such as lump sum annual contributions, will be caught by the anti-forestalling provisions.

Having said that, you will not generally be penalised if your total annual contributions are no more than £20,000.

In summary, there is still scope for those earning £150,000 or more to enjoy higher-rate tax relief for the next couple of years, providing you fully understand the anti-forestalling provisions.